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September 2012
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Jury’s Out on Question of Sequester

Suppliers to the defense industry who have prospered for the past decade are now bracing for the possibility of massive, triggered cuts to government spending.

By Dan Markham, Senior Editor

For the past decade, metals suppliers to the defense industry have enjoyed a robust business, a byproduct of global conflict. But a different type of threat looming on the horizon has metals producers and distributors shaking in their boots—sequester. Defense contractors say that single concept is the difference between a manageable drawdown of demand from the military sector and utter unpredictable chaos.

Sequestration is the term used to describe the automatic, across-the-board default spending cuts that were included in the Budget Control Act of 2011. They were designed as a stick to force Congress to come to a bipartisan solution on spending cuts during the contentious budget talks last year for fiscal year 2013 and beyond. But the committee appointed to make recommendations on austerity failed to reach a consensus, leaving the door open for sequestration, which would trigger roughly $1 trillion in cuts to federal spending over the next decade.

The Department of Defense alone is facing upwards of $500 billion in cuts—a possibility that terrifies individuals in the military, in the political arena and throughout the supply chain.

Secretary of Defense Leon Panetta is among many who have expressed fears of the effects of such automatic cuts to the defense industry. “Too often today the nation’s problems are held hostage to the unwillingness to find consensus and compromise. And in the face of that gridlock, artificial devices like sequester are resorted to in order to somehow force action. But in the absence of action, sequester could very well threaten the very programs critical to our national security, both defense and domestic,” he said in June.

Service center operators who sell into the defense industry agree. “There is no doubt the government needs to cut spending overall, in all the departments,” says Ken Hamel, president of Diversified Metals, Monson, Pa. “But the defense spending cuts being considered worry me. The proposed cuts are much too aggressive.”

How likely is sequestration? Initially, most thought Congress would eventually reach a solution that would, if not solve the budget issue, at least kick it further down the road. But as the start of Fiscal Year 2013 approaches in October, the threat is becoming more real.

“In theory, this being an election year and defense being important to the economy, it wouldn’t stand much of a chance of actually happening,” says Richard Aboulafia, vice president of analysis with the Teal Group, Fairfax, Va. “But there have been major political changes that make this a very real threat. You used to be able to count on the Republicans to save the day, but the Republicans are shifting to a Tea Party agenda. They’re shifting away from being defense hawks and foreign policy hawks toward deficit and tax hawks. So it’s not really clear they’re going to ride to the rescue.”

Still, he says, the smart money remains on a solution before then. The system in Washington was created to avoid radical shifts like the one speculated. “It will become easy to postpone the problem with continuing resolutions or with a negotiated deficit reduction plan next year, or something else that keeps the worst of the cuts from being implemented.”

Though the 2013 fiscal year for government spending begins in October, sequestration would not take effect until January. Still, if it happens, any programs are immediately subject to the loss of funds, even ones already under way.

Jim McAleese, defense analyst with McAleese & Associates, Sterling, Va., says the impact would be felt most noticeably in the worst area for metal distributors.

“Sequester would primarily collapse procurement, since services cannot immediately shed force structure in 2013.” Historically, during such forced cuts, procurement budgets have dipped 50-75 percent, easily the largest hit among the four main defense expenditures.

Even if Congress rescues the defense industry from sequester, some of the damage has already been done. Uncertainty has begun to creep into the supply chain, which is never good for efficiency.

“Congress, in writing the Budget Control Act, did not design sequester to be rational. And irrationality and uncertainty are subjects of concern to the defense industry. This is not the way to do defense planning and budgeting. Instead, we need to take a rational strategic approach to our budgeting,” said Deputy Defense Secretary Ashton Carter in May.

Distributors serving the industry have seen that in action with their customers. “They’re quite uneasy. There’s some slowness and hesitancy while they’re waiting for funding to come through,” says Pat Able, general manager of the government business unit for TW Metals, Exton, Pa.

Even without sequester, government spending is undeniably going to decline. The Department of Defense has proposed a budget cut of $259 billion from fiscal years 2013-2017. These would be cuts in the Beltway sense, as “the majority of the initial $259 billion in 2013-17 DoD budget cuts under BCA are actually the forfeiture of future planned funding growth,” says McAleese.

The Budget Control Act also establishes a statutory floor in defense spending at the same level as previous war-time peaks. The key question, McAleese asks, is whether the debt reduction compromise will actually take the budget down to its historic floor of $400 billion, more than $100 billion less.

In any event, procurement will face significant cuts in the coming years. While the 2013 fiscal plan only calls for a 5 percent cut, that area of spending will take the bulk of the hit for the 2013-17 period. The Department of Defense office proposes $94 billion in cuts from procurement during that time frame, representing 36 percent of the $259 billion total.

Within the individual branches, the Navy will sacrifice aircraft procurement to retain its shipbuilding budget, while the Air Force will target its cuts at airlift procurement and combat aircraft. Army procurement will flatline at a lower base level near $20 billion, almost half its average in the recent past.

This is consistent with what Aboulafia sees as a change in focus from the campaigns fought in Iraq and Afghanistan. “It looks like you’ll be seeing a shift away from the ground vehicles toward ships, aircraft and strategic systems. The unpleasant reality is that the great upturn [in spending] of the last decade didn’t help the traditional superpower tools at all. All the funding went towards body armor and mine-resistant ambush protection vehicles. The challenge is how to keep the money coming for actual strategic systems rather than just war fighting,” he says.

Some such changes are already evident. Keith Harvey, senior vice president of sales and marketing for Kaiser Aluminum, Foothill Ranch, Calif., says his company’s armor business pushed capacity for much of the past decade, but cooled considerably in 2010 as the shift away from MRAPs and Humvees began.

But Kaiser’s defense business overall has remained healthy. “Defense in the last 10 years has been fairly steady. It gives extra boost to some of our really strong years and really filled in during 2008-09,” he says.

Service center operators tell a similar story. “It’s been positive, in spite of all the news we hear about defense cuts,” says Jerry Bashir, president of Falcon Aerospace, Weston, Fla. “We may see some cuts for the large vehicles, but we continue to see good things in armaments.”

Able offers similarly positive observations about materials for maintenance and repair work, a prominent end use for the products TW Metals supplies to the defense industry. As the recent past has demonstrated, conflict that sparks U.S. involvement can break out anywhere on the globe at a moment’s notice, mandating that work gets done to keep equipment in proper condition. “When you look at defense as a total industry, the real focus is on fleet readiness,” says Able. “We learned that lesson about 10 years ago in Afghanistan, when we weren’t ready and spent the first several years ramping up.

That attitude, many believe, trumps politics. So while the presidential election will be closely followed by the defense sector, the ultimate result probably won’t have much of an impact on the market. Though there was some concern among suppliers when a Democrat was elected president in 2008, any fears of drastic defense spending cuts never materialized.

“There was some trepidation when Barack Obama got in, that he might cut back on spending. But he’s maintained the same type of defense budget as his predecessor,” says Rich Carbone, president and CEO of Tech Steel and Materials, Holbrook, N.Y.

That seamless transition tells Carbone that the defense market is somewhat immune to the political squabbling in Washington. Both parties acknowledge the genuine threat of terrorism and the need to be vigilant, while the economic benefit of a strong defense sector is felt nationwide. “When you look at defense spending, it’s spread throughout the whole country,” he says. “There may be some hubs, but the distribution is pretty equal. It’s an engine that generates a lot of jobs.” And congressional representatives of both parties are very protective of jobs in their districts.

Even if the levels remain the same, the way government spends its money is always being refined. Changes in leadership, in the executive branch or below, can lead to new approaches to procurement that affect service centers. For example, the demand for quality in all aspects of supply chain management has increased as the federal government looks to improve efficiencies.

“On the quality side of the business, you’d better have your capabilities and qualifications and certifications in line,” says Harvey. “They are very stringent on those types of things. Not everybody and their brother can make these products.”

Carbone’s company recently qualified for ISO 9000 certification specifically to meet the demands of one of its defense customers. “They sent out a mandate saying that anyone who wants to participate with them must have this level of quality,” he says.
 
Of course, it’s easy for the government’s approach to slide from cautious to burdensome. “Lately a tremendous amount of additional oversight has been brought on by the DoD. Sometimes I feel it’s to justify certain departments being opened,” says Michelle O. Allinson, vice president of sales and marketing for Aerospace Alloys Inc., Bloomfield, Conn. “We’re seeing people scrutinizing things to the point of overkill.”

Able says his company has seen a trend toward more long-term contracts, possibly because of the defense department’s plans for a workforce reduction. “There’s been a big turnover in personnel. They don’t have the same level of experience or the manpower, and that’s affecting contracting.” The government’s attitude toward cost cutting will undoubtedly play out when it comes to purchasing, he adds. Inventories will be kept lower and demands higher as the defense supply chain strives to make its dollars go further.

Aboulafia agrees. “You’re starting to see contracts go from cost-plus to fixed-cost at an earlier stage in the program. You’re also seeing more talk, if not reality, of work being shifted from the private sector to the government.”

Government suppliers should brace themselves for a market where lower margins are the rule, he says. “The last few years were an exceedingly good environment for defense contractors. Now, it’s less so.”

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